October 27, 2010 Leave a comment
Real Estate Investment Trusts have outperformed the S&P 500 by nearly 30% in the last year. This has pushed an already low dividend yield even lower to 4.36%, a level below the yield of any other time except for a few weeks in April of this year, and a nine month period at the peak of the real estate bubble. Coming so soon after a bubble, this is slightly surprising. Valuations after a bubble tend to stay low for a while as the memory of the bubble is still fresh in investors minds.
With the dividend yield this far from normal, future real returns will probably be low. The primary source of returns from REITs is dividends, so a low yield is a strong indicator that returns will be below average. Unlike stocks, there has been pretty much no growth in fundamental value of REITs in the past. Because they must pay out most of their earnings as dividends, most REITs don’t grow without raising capital. This is reflected in the past dividend growth of the FTSE NAREIT index, which has not changed much from zero over the full business cycle.
In addition to a low return from dividends, it is also possible that we will see a drop in prices if investors demand higher yields. For the dividend yield of REITs to return to its historical average, REIT prices would have to drop 47%. However, with interest rates at extremely low levels, it may be that the dividend yield of REITs will remain low while the Federal Reserve keeps interest rates down. If this is the case, than valuing REITs relative to treasuries should be insightful. When this is done via the yield spread, REITs no longer appear overvalued.
The yield spread, currently at 1.67%, is higher than the historical average of about 0.9%. The key here, though, is that this is relative to treasuries. If treasuries have very poor returns, than a slightly higher return is still likely to be unsatisfactory.
Disclosure: No positions in REITs